Is auto leasing right for you?

Q: We have a car that is getting on in years and we’re getting ready to get a new one. Someone said that leasing might be better than purchasing for us. Please give us some background and ideas on how to decide. – S. J., Arizona

A: Leasing a car has become popular in recent years largely because it often seems more affordable than buying a new car. But whether or not leasing a new car makes sense for you depends on more than your finances.

THE BASICS

Whether you lease or buy, if you want to get a good deal and be happy with the car you drive home, you have to do some homework first. Once you’re armed with price and reliability information on the models you’re interested in, you should shop around to find the best deal. Negotiating the best possible price is the most important step.

Many people who want to drive a new car don’t have the cash to cover the entire purchase (plus tax), so they make a down payment and then take out an auto loan. Unfortunately, financing the purchase of a new car is not a great money-making decision because you end up paying interest on an asset that is worth less and less each year.

Leasing is basically a way for you to drive a new car and pay for what you use. The lease payments cover the car’s depreciation and finance costs during the term of the lease.

LEASING BENEFITS

Lower monthly payment
Low down payment or no down payment
Amortized sales tax (in most states), meaning that you pay sales tax on your payment a month at a time rather than all at once
You can drive a more expensive car than you can afford to buy
You can get a new car every two to four years (depending on the lease term)
No major repair costs (the lease term should be covered by the original warranty)
No hassles or headaches getting rid of the used car at the end of the lease
Extended “test drive” (if you like the car, you can buy it at the end of the lease)

LEASING DOWNSIDE

At the end of lease, you do not own the car
It is easy to be confused in negotiating the deal — the dealer may emphasize the low monthly payments compared to buying, without making clear that the actual price for the car is higher
Limited annual mileage — for example, miles over 12,000 per year may cost 15 cents to 20 cents each
You have to keep the car in very good condition, allowing only “normal” wear and tear
Early termination penalty if you have to break the lease

COMPARING COSTS

The cost of leasing for three years may be very much the same as taking out a loan over the same three years. It all depends on the following:

Vehicle price
Interest rates on the loan vs. the lease
Amount the lease contract states the car will be worth at the end of the lease (called “residual value”) compared to the actual market value of the car when the lease is over

EXAMPLE 1

Consider a $20,000 car that you can purchase with a $3,000 down payment and finance with a five-year loan for $17,000 at 7.5 percent interest. You can pay off the loan at the end of three years. The same car can be leased for a three-year term at an annual percentage rate of 6 percent. The lease terms also state that the car’s residual value after three years is 65 percent, or $13,000.

First, compare the direct cash outlays:

	Loan	Lease
Up-front outlay(not including taxes)	$ 3,000	$ 600
Total payments over 36 months	12,263	10,006
Pay off the loan	7,570	0
Lease-end fee	0	150
Total cost	$22,833	$10,756

To enhance this comparison, it also makes sense to include the cost of having your money tied up in the purchased car when it could have been earning interest. In this case, your initial outlay of $3,000 is $2,400 more than the $600 for leasing, and the payments each month are $63 more on the purchase.

This money could have been earning interest for three years. If invested at 3 percent (to cover inflation), the interest earned over three years would be $327. Therefore, taking into account this lost interest, the car purchase costs an additional $327 more than the lease.

	Loan	Lease
Total cost (from above)	$22,833	$10,756
Plus forgone interest	327	0
Total cost	$23,160	$10,756

Leasing the car thus costs $12,404 less over the three years, but you do not own a car. So, to make the comparison equivalent, let’s assume that you sell the purchased car and get $11,500 for it.

	Loan	Lease
Total cost	$23,160	$10,756
Minus price from selling car	– 11,500	0
Total cost	$11,660	$10,756

Here, the lease saves you $904 over the three-year term compared to buying the car with a loan. In this example, this averages out to about $300 per year. The key here is the value of the car after the lease period, and the financing terms on the purchase and lease sides.

EXAMPLE 2

There are other ways to compare the costs of leasing vs. buying. The one that follows has you purchase the lease car at the end of the lease. This makes the lease cost more than buying, rather than vice versa as in Example 1.

Assume the same background as above on the car’s price and lease options. If at the end of the lease, you purchase the car for its residual value of $13,000, then your costs would be:

	Loan	Lease
Total cost	$23,160	$10,756
Plus cost of purchasing car		13,000
Total cost	$23,160	$23,756

Here, the lease costs $596 more than buying.

BOTTOM LINE

Compared to buying a new car and taking a loan for most of the purchase price, and depending on the lease rate and terms and the loan rate and terms:

Leasing is less expensive at the beginning.
Monthly lease payments are lower than loan payments.
Over the course of three or four years, leasing costs about the same as a loan.
Over the long term, leasing a personal use car is more expensive than buying. Buying a car and keeping it for nine years clearly is a lot less expensive than leasing three cars for three years each.
If you are a business owner, there are some special tax benefits for you. Before making the decision, have your tax adviser prepare an after-tax analysis for you.

An additional word of caution: When you finance or lease a new car, the car’s market value is often less than the amount you owe on the balance. This happens because the car depreciates in the first few years more rapidly than your balance declines.

Guaranteed Auto Protection (GAP) insurance provides protection from financial loss when the vehicle is stolen and not recovered or if the car is severely damaged and cannot be repaired. Your auto insurance will pay what the car is worth at the time of the loss, and GAP will make up the difference to reach your outstanding payment balance.

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